Why the long face?

A horse walks into a bar. The barman looks up at him and asks "Why the long face?"Another day, another record low in the dollar against the euro and the loony. Indeed, EUR/USD now isn't far off from the all time USD/DEM-equivalent extreme; a repeat of Thursday and Friday's price action would carry the buck into record territory.

Fresh highs in oil (courtesy of a production outage in Mexico) and news that OPEC may consider switching to a currency basket for pricing have helped depress dollar sentiment this morning, and shorts are no doubt high-fiving each other and kicking up their heels in glee.

Or are they? For a look at the currency options market reveals few signs of euphoria, or indeed crisis, that one might ordinarily expect to see at dollar extremes. For one thing, the level of implied volatility is still quite low: one month vol is currently quoted around 7.6%, which is the high of the last couple of months but still well below the levels observed in August.

More telling is the skew in the market- the vol premium or discount that participants are willing to buy euro calls over euro puts of an equivalent delta. Normally, with EUR/USD at its highs, one might expect calls to command a handsome premium over puts as players look to profit from/hedge against further gains. And over time, there generally is a good correlation between spot moves and risk reversal skew. The chart below shows 12 week changes in EUR/USD with the 1m 25 delta risk reversal skew, with positive readings showing a premium being placed on euro calls, and negative readings showing a premium on euro puts. Whats remarkable is that despite the strong rally in EUR/USD to record levels, options skew has remained firmly bid for puts. Far from crisis or euphoria conditions, it looks like most currency punters are worried about a corrective rally in the dollar. What's worrying from the dollar bear's perspective is that the last such obvious dissonance, in Q4 2004, heralded a blow-off top in EUR/USD and ushered in 12 months of dollar strength. Should dollar bears be quaking in their boots even more?

Macro Man constructed a simple study to find out. He regressed the data above, 12 week EUR/USD spot moves against the level of the 1 month risk reversal. He then checked the residual against EUR/USD spot moves in the subsequent 8 weeks. The resuts are depicted in the chart below. In summary, sometimes the disconnect is a useful leading indicator......and sometimes it isn't. As you can see in the chart, in late 2004 the residual perfectly called the trend reversal in EUR/USD. However, there have been plenty of other times when the residual completely missed the boat. Over the last four years, the correlation between the risk reversal residual and the subsequent eight week spot move has been 0.14; postive, but not significantly so. So while this is clearly a situation that's worth keeping an eye on, the continued bid for EUR/USD downside does not in and of itself provide conclusive evidence that the end is nigh for dollar weakness. Macro Man continues to wait for The Economist to signal that.

Of course, currency punters hardly have a monopoly on pessemism. Results from Macro Man's recent poll were not as lopsided as August's result, but it's still telling that both market pros and retail punters viewed S&P upside through year end as the least likely outcome. Moreover, futures positions remain heavily skewed to the short side. Macro Man's preferred measure is a diffusion index which looks at the net positioning of the S&P and e-mini futures as a percentage of the open interest. As can be seen in the chart below, net index futures shorts as a percentage of the O.I. are near their extremes of the past several years.

Of course, hedging by long/short and market neutral funds, as well as by macro men, is a possible explanation. By the same token, that still begs the question of how net futures length has fallen so precipitously over the course of 2007. The wall of worry would appear to be fully intact, and the potential for short squeezes, especially in light of what the market takes to be favourable developments, would seem to remain high.

That having been said, given the recent rally and this week's event risks, it would appear churlish not to hedge, and Macro Man may look to do so later today.

MM - i know your the expert in these markets, but is this Oct move really about the dollar, or is this move really about a recovery of leveraged fx spec - a phenom independent from subprime & large-institut credit woes?? Forgive me for asking, but are not cable & euro strength and continued Yen & CHF squishiness, along with new highs in all the high-yielders vs. the funding whore-units a tell-tale that while the USD while indeed adrift, but not completely scuttled?

In equity markets, for example, a dominant feature at the moment is the strength and persistence of certain single-factor cross-sectional returns - particularly in momentum, which itself aliases other growth and expectational factors themselves related to "the global spec factor" which I reckon is liquidity and neg rates. In FX, from casual observation, the single-factor returns appear wholly rates-driven, the relative structure being both the best explanation of yests returns and finest predictor of tomorrows. From a casual distance, this appears to be swamping the fundamental trade else USD would be far weaker vs. CHF and Yen than it is. Any thoughts?

C, I actually think that's exactly what isn't happening, e.g. what's different about the last couple of weeks.

Since the buck made its half-hearted attempt at a rally in early October, EUR/USD has rallied from 1.4050 to 1.44. But USD/JPY has fallen from 117.60 to 114 (Ok, it's rallied a smidge so far today.) So EUR/JPY, rather than being the "uber-dollar", which reflects an environment of carry -at-all-costs speculation, has been a mere spectator to dollar weakness of the last couple of weeks.

This may reflect the change in Japanese securities law, which nowrequires purveyors of toshin to actually inform Mrs. W what she is getting into...and has thereby slowed the outflow from Japan.

Yet the fact that erstwhile laggards the MXN and ZAR are plumbing extremes against the buck suggests, to me at least, that this has broadened out into more of a bitchslap-Geogre Washington kind of party.

Not to say that mechanistic carry trading is dead-far from it!- but it seems to me at least that the downward pressure on the dollar is now equal to, if not greater than, the equivalent pressure on erstwhile turds the yen and Swissie.

And that is a bit of a different dynamic- indeed one could argue the opposite of whats going on in equity land, where index strength is driven by an ever-narrower band of brothers; in other words, the trend is becoming more selective under the surface, whereas the weak buck is becoming more inclusive.

I asked a co-worker to call into the repo desk we deal with and the $70mm @ 15% was real and done at the end of the day when someone was caught short of reserve requirements. It's peanuts...but the $400mm @ 7+% that's being debated on around on some discussion forums looks more ominous. It's certainly possible that the credit crunch is back and that this year's annual year end funding problem might be a real ticking time bomb.

Anonymous, thanks. Of course, all of this begs the question of why not borrow at the discount window, unless the collateral posted was of insufficent to queue up at this particular trough.

While there may well be year end funding/credit issues, it's not difficult to construct a scenrio, a la 1999, where the Fed open market desks floods the market with liquidity well in advance, which then somehow fids its way into equities...which then melt up. Hmmm...perhaps I should roll my short strike higher (or cross my fingers it doesn't start til after November 17.)